What Are the Pros and Cons of Life Insurance Policy Loans?

You have to own a whole or universal life insurance policy if you want to borrow from your life insurance. Term life insurance policies do not have a cash value component, so they are not eligible for loans. However, if you own permanent life insurance (whole or universal) and you have built up a reserve of cash within it, you can usually borrow from it.

However, like any type of loan, life insurance policy loans come with pros and cons. It is important to look at both aspects before deciding whether to borrow against your whole life insurance policy.

Pros of a Life Insurance Policy Loan

Getting a life insurance policy loan is quick and easy. Since you are borrowing against your own assets, there is no approval process, credit check, or income verification. Policy loans generally have a much lower interest rate than bank loans and are devoid of high fees and closing costs. In most cases, they are also tax-free. After you request the loan, a check is usually received in five to 10 business days.

Funds from a policy loan can be used any way you choose. Because your policy's cash value acts as collateral for the loan, you can use the money for anything from household bills to a vacation. The insurance company does not require an explanation as to how you intend to use the funds. Unlike with a bank loan or credit card, there is no required monthly payment for a policy loan and no payback date. You can pay it off in two months or let it sit without making any payments for years. However, even if no payments are made, the loan accrues interest that is added to the balance of the loan.

Policy loans are not considered taxable income as long as the amount borrowed is equal to or less than the amount of premiums paid. Since the loan is borrowed against your own assets and does not hit your credit, the IRS does not recognize the loan as income; therefore, it is not taxed.

Cons of a Life Insurance Policy Loan

If you were to die before paying back your policy loan, the loan balance plus interest accrued is taken out of the death benefit given to your beneficiaries. This could be a problem if your beneficiaries need the entire amount of the intended benefit. When the loan sits unpaid, the interest that accrues is added to the principal balance of the loan.

If the loan balance increases above the amount of the cash value, your policy could lapse and risk termination by the insurance company. In the event of a policy lapsing or being surrendered, the loan balance plus interest is considered taxable income by the IRS, and the taxes owed could be a fairly large amount depending on the initial loan and interest accrued.

Borrowing from your cash value may result in the collateral amount being moved from an investment account into a secure account. Any dividends earned on the investment account are decreased based on the amount of collateral secured.

The Bottom Line

A big benefit of permanent life insurance is its cash value component, which you can legally borrow after it builds up. The funds are tax-free, and if you pay yourself back in a timely manner, it can be a beneficial way to use your policy.

There are not often timetables associated with these loans because payback on them is optional. However, you will have to pay the interest that is accused on the loan and if the loan and interest become larger than the cash value in your account, you may get hit with a tax bill and your death benefit may be reduced.

In addition, if you don't pay back the money you borrow, your cash value will shrink and if the money borrowed exceeds your cash value, you could owe taxes on the money you borrowed. Weighing the pros and cons of borrowing from a life insurance policy can allow you to make an informed decision about what can end up being a complicated loan.